America's Coming Debt Limit Crisis

Document Sample
America's Coming Debt Limit Crisis Powered By Docstoc
					                                               JANUARY 21, 2011


America’s Coming Debt
Limit Crisis

• Bank of Canada on Hold; Modestly Dovish
  Despite Raising Growth Projection

• Strong Canadian Retail and Wholesale Trade
  Offset Weak Manufacturing

• China’s Economy Accelerates

• U.K. CPI Jumps, Retail Sales Slump…
  BoE Dilemma

• Brazil Hikes Rates
                                                                                                Our Thoughts
                                                    Three weeks into 2011, and markets are none the wiser. Stocks,
                                                    commodities and currencies have essentially fought to a draw, although
                                                    U.S. bond yields are still marching higher while gold has lost some shine.
                                                    Economic data and earnings have been generally positive, but not
                                                    strong enough to alter the landscape. That trend continued this week,
                                     DOUGLAS PORTER with U.S. jobless claims easing markedly, home sales finishing 2010 with
                                    a bounce, and the Philly and NY Fed surveys solid. However, home building remains
                                    desperately weak, and mortgage applications for purchase are sagging amid the back-
                                    up in Treasury yields, which has seen a 100 bp rise at the long end in just the past six
                                    months. Even with a generally better outlook for the U.S. economy, and a welcome
                                    dearth of double-dip chatter, broader markets are still wary amid three other major
                                    concerns. We come not to bury those concerns, but also not to praise them either.
                                          First, concern is growing that China’s hot growth and inflation will prompt even
                                    more aggressive tightening there, leading to a sudden global slowdown. Those fears
                                    were slightly allayed by news that the CPI eased to 4.6% y/y in December from the two-
                                    year high of 5.1% the prior month. That calm lasted all of one day when it soon emerged
                                    that GDP roared ahead 9.8% y/y in Q4, accelerating from 9.6% in Q3, and averaging a
                                    rocking 10.3% for all of 2010. I vividly recall in the middle of last year some fretting that
                                    Europe’s debt crisis would clobber China, leading to a marked slowdown. Some
                                    clobbering. Some slowdown. But I digress. Commodities took it on the chin following
                                    the GDP news, fearful that China will tighten much more dramatically. It may seem
                                    frightfully old-fashioned, but there once was a time when news of strong growth
                                    prompted strength in commodities. Now I realize that markets are forward looking, and
                                    this GDP report covers ancient history (stretching back more than three weeks ago!), but
                                    perhaps the more important point is just how robust the underlying trend in China’s
                                    economy truly is. Even a more aggressive tightening campaign may not significantly
                                    brake this locomotive, especially if U.S. demand begins to gather strength.
                                          A second lingering concern is the ongoing debt trauma in Europe. While we
                                    wouldn’t downplay this risk—debt never takes a holiday, and Europe faces years of
                                    very real restraint—note that German business just reported to the Ifo that they are as
                                    confident as they have ever been in 20 years of surveys. Now if businesses are
                                    sanguine in the major country that is arguably the most exposed to the risks of an EU
                                    sovereign debt blow-up, and/or potentially on the hook for most of the costs, why is
                                    the rest of the world so fretful about the issue? Are we missing something, or are they
                                    whistling past the graveyard? We would also note that, aside from the crisis countries,
                                    European stocks enjoyed a rock solid year in 2010, and almost all markets there are off
                                    to a fiery start in 2011, led by some of the PIIGS. And, sovereign bond spreads have
                                    narrowed substantially since the start of the year, led by Spain—although we all know
                                    that can turn on a dime.
                                          Finally, a third concern that continues to ping-pong around in markets is the
                                    hobbled finances of U.S. state and local governments. California Governor Brown
                                    declared a state of emergency amid this year’s projected $25 billion shortfall in the
                                    state, and a New York Times article suggested officials are pondering ways to allow
                                    states to seek bankruptcy protection. The yields on state & local bonds have gapped

PAGE 2 – FOCUS – JANUARY 21, 2011
                                                                                                        Our Thoughts

                                    up more than 150 bps in the past three months alone, widening the spread with 20-
                                    year Treasuries to more than 1 percent (when historically these tax-favoured issues
                                    have yielded less than Treasuries). Again, we would not downplay the seriously sad
                                    state of local finances, and closing the budget gaps will inflict very real restraint on the
                                    economy this year. But note that local governments have already been dragging
                                    heavily on the recovery, alone chopping 256,000 jobs in the past year (or 21,000 per
                                    month). Moreover, while the totals sound daunting, the combined projected deficit of
                                    the states is likely around US$125 billion, less than 1% of GDP and less than 1/10th of
                                    Washington’s shortfall. Put another way, the bailout package for Ireland, with a
                                    population of barely 4 million, was alone more than $115 billion. It’s a serious issue,
                                    but lets keep some perspective.

                                                   The Canadian government’s decision to tighten mortgage rules for the
                                                   third time in three years should moderately dampen home sales and
                                                   prices this year, but only slightly restrain the economy. The moves to lower
                                                   the maximum refinancing amount from 90% to 85% of a home’s value,
                                                   and to no longer insure new home-equity lines of credit, will likely restrain
                                      SAL GUATIERI borrowing and spending somewhat, particularly for renovations and
                                    second homes (cottages, Florida retirement properties) and other big-ticket items often
                                    funded through mortgage refinancing or HELOCs. However, most homeowners aren’t
                                    brushing up against the current refinancing limit. According to the Canadian Association
                                    of Accredited Mortgage Professionals, owners with mortgages had 50% equity in their
                                    homes on average as of October 2010, and only about one-in-ten had less than 10%
                                    equity. Fewer than one-in-five borrowers withdrew equity from their home or increased
                                    their mortgage principle in the past year.
                                           The more substantive impact will stem from the move to lower the maximum
                                    amortization period (on insured mortgages) from 35 years to 30 years. This change,
                                    after spurring an initial burst of activity before taking effect on March 18, will no doubt
                                    persuade some buyers to rent (good news for landlords) and others to seek lower-
                                    priced homes. For the typical buyer—putting 5% down on an average priced home
                                    ($345,000) financed at 4.5% interest (the typical 5-year fixed mortgage rate last
                                    month)—the shorter term will increase annual mortgage costs by $1320. That’s
                                    equivalent to a one-half percentage point increase in mortgage rates and a 7%
                                    reduction in housing affordability, enough to squeeze marginal buyers out of the
                                    market. Those buyers wanting to keep mortgage costs unchanged at the new 30-year
                                    term will need to settle for, or bargain for, a house that costs 7% less than the one they
                                    could have bought with the 35-year term, thereby putting some moderate downward
                                    pressure on prices. Although the 30-year term will ultimately save homebuyers tens of
                                    thousands of dollars in interest payments compared with the 35-year term, the annual
                                    cost of servicing the mortgage will be $1320 higher, which is money that could be
                                    spent on other things. How much money in aggregate? According to the CAAMP, 30%
                                    of new mortgages had 35-year terms in the year to October (as well, 35-year terms
                                    accounted for 8% of all mortgages). Even assuming, in the most conservative manner,
                                    that the same proportion of buyers chooses a 30-year term going forward, and that

PAGE 3 – FOCUS – JANUARY 21, 2011
                                                                                                            Our Thoughts

                                    not a single buyer leaves the market or buys a lower-priced home, the higher average
                                    mortgage cost ($1320) would apply to fewer than 160,000 home sales this year
                                    (including a crude estimate of new home sales). This is less than a quarter billion
                                    dollars, or a tiny 0.02% of disposable income.
                                          All in, the new mortgage rules are unlikely to have a meaningful impact on
                                    Canada’s economy this year, thus we still look for 2.7% growth. However, to the extent
                                    that the changes will help reduce the risk of an unsustainable increase in both house
                                    prices and household debt, they should weigh on the side of a more gradualist course
                                    of monetary policy renormalization.

                                                     In 2010, copper extended a rally that began after hitting lows at the end
                                                     of 2008. There was marked volatility during the first half as markets
                                                     digested the demand implications of European sovereign debt, Chinese
                                                     monetary tightening, and a possible U.S. double-dip recession. However,
                                                     once these threats eased, copper scaled successive highs in the second
                                      KENRICK JORDAN half, ending the year at a record high. The rally has continued unevenly in
                                    January, with the LME benchmark hitting a record US$4.41/lb. on January 18th. Over
                                    the past two years, copper outshone gold and many industrial metals by large margins
                                    as its price almost tripled.
                                            Several factors have driven the rally, including: robust growth in industrial
                                    production, especially in emerging markets; paltry increases in supply due to a lack of
                                    investment, falling ore grades and periodic supply disruptions; and heightened
                                    investor interest. Demand has surprised on the upside partly due to stronger-than-
                                    anticipated consumption in some advanced countries. Overall, with demand
                                    outstripping supply, exchange inventories have fallen notably as the market has
                                    moved sharply into deficit. LME inventories, for instance, have shrunk about one third
                                    from peak levels last February.
                                            Demand is projected to grow solidly again this year, and industrial use could prove
                                    stronger than anticipated, given improving prospects in the U.S. and parts of Europe.
                                    Likewise, investor demand, aided by physically-backed ETFs and substantial liquidity in
                                    financial markets, could exceed expectations. Meanwhile, output growth is set to remain
                                    sluggish, given a lack of new projects, declining ore grades, and the odds of supply
                                    disruptions as mine workers seek a bigger share of the industry profit pie. With another
                                    large market deficit on tap, there is the potential for another substantial price rise this year.
                                            Two key risks to this outlook relate to: (i) the role of physically-backed ETFs in
                                    facilitating investor participation and lifting prices, and (ii) the potential for a slowdown
                                    in China. Rising demand by investors for copper-based ETFs and corresponding
                                    increased purchases by fund managers to physically back their investment vehicles
                                    ultimately build inventories. If an aggressive response by copper producers to high
                                    prices eventually boosts supplies, this could cut prices. Such a decline could be
                                    accelerated if investors exit their ETFs and fund managers are forced to sell their copper
                                    into the market. Concerning China, it has so far managed to achieve strong economic
                                    growth despite past tightening moves. However, it requires close monitoring, as China
                                    remains the driver of global copper consumption.

PAGE 4 – FOCUS – JANUARY 21, 2011
Jennifer Lee, Senior Economist
                                                     GOOD NEWS                                                           BAD NEWS

                                      Retail Sales +1.3% (Nov.)                                          Manufacturing Sales -0.8% (Nov.)
CANADA                                Wholesale Trade +1.2% (Nov.)
• BoC stays on hold, and MPR still    Manufacturing New Orders +1.6% (Nov.)
  sounds cautious
                                      Leading Indicator +0.5% (Dec.)
• Ottawa announces tougher
                                      Foreigners buy a net $8.0 bln of Canadian
  mortgage rules
                                      securities (Nov.)

                                      Initial Claims -37,000 to 404,000 (Jan. 15 wk)                     NAHB Housing Index unch at 16 (Jan.)
UNITED STATES                         Existing Home Sales +12.3% to 5.28 mln a.r. (Dec.)                 Housing Starts -4.3% to 529,000 a.r. (Dec.)
• Jobs outlook improves               Building Permits +16.7% to 635,000 a.r. (Dec.)—but                 Redbook -0.6% (Jan. 15 wk)
• U.S.-China summit brings            due to building code changes effective January                     Philly Fed Index -1.5 pts to 19.3 (Jan.)
  US$45 bln in new trade deals        Leading Indicator +1.0% (Dec.)
                                      Empire State Manufacturing Survey +2.0 pts to
                                      11.92 (Jan.)
                                      Foreign net purchases of long-term U.S. securities
                                      $85.1 bln (Nov.)

                                      Tertiary Industry Index +0.6% (Nov.)                               Consumer Confidence slips 0.4 pts to 40.2 (Dec.)
JAPAN                                                                                                    Department Store Sales -1.5% y/y (Dec.)
• Economy still sputtering                                                                               All-Industry Activity Index -0.1% (Nov.)

                                      Germany—Ifo Survey +0.8 pts to 110.3 (Jan.)                        Eurozone—Consumer Confidence slides to -11.4
EUROPE                                Germany—ZEW Survey +11.1 pts to 15.4 (Jan.)                        (Jan. A)
• Some ECB officials hawkishly        France—Business Confidece +1 pt to 106 (Jan.)                      Germany—Producer Prices +0.7% (Dec.)
  warn not to focus too much on                                                                          Italy—Industrial Orders -4.3% (Nov.)
                                      U.K.—Jobless Claims -4,100 (Dec.)
  core prices
                                      U.K.—Rightmove House Prices +0.3% (Jan.)                           U.K.—Consumer Prices +1.0% (Dec.)
• Eight-month high inflation
                                      U.K.—Nationwide Consumer Confidence +8 pts to                      U.K.—Retail Sales -0.8% (Dec.)—weather related
  pushes up BoE rate hike
  expectations                        53 (Dec.)
                                      U.K.—RICS House Price Balance +5 pts to -39 (Dec.)

                                      Real GDP +9.8% y/y (Q4)                                            Foreign Direct Investment slowed to
CHINA                                 Industrial Production +13.5% y/y (Dec.)                            +15.6% y/y (2010)
• Economic growth remains             Retail Sales +19.1% y/y (Dec.)
  strong, but fans fears of further
                                      Consumer Prices slowed to +4.6% y/y (Dec.)
                                      Producer Prices cooled a tad to +5.9% y/y (Dec.)
                                      Property Prices eased to +6.4% y/y (Dec.)
                                      Fixed Asset Investment +24.5% y/y (2010)

                                                   Indications of stronger growth and a move toward price stability are good news for the economy.

PAGE 5 – FOCUS – JANUARY 21, 2011

                            America’s Coming Debt Limit Crisis
                            Michael Gregory, CFA, Senior Economist

                            This year marks the 70th anniversary of the Public Debt Act of 1941, legislation that clearly
                            established an aggregate limit for nearly all debt issued by the U.S. government (see the
                            Appendix for a brief discussion on the public debt). Lifting the debt limit is often politically
                            contentious, sometimes becoming a “crisis”. When an agreement to raise the debt ceiling isn’t
                            reached in time, and the limit is hit, the government can no longer issue net new debt. This is
                            when a crisis begins. Consider the current situation: Treasury is issuing net new debt to finance
                            the $1.4 trillion budget deficit, which includes interest payments on the $14 trillion debt
                            outstanding. The inability to issue net new debt would result in the U.S. government, technically,
                            defaulting on the debt.

                            Treasury Secretary Geithner wrote to Congress on January 6 stating that if the current $14.3
                            trillion limit is not lifted, public debt could hit the ceiling as early as March 31 and by as late as
                            May 16 (Chart 1). Mr. Geithner was not employing hyperbole when he argued that default would
                            cause “catastrophic damage to the economy, potentially much more harmful than the effects of the
                            financial crisis of 2008 and 2009.” With global financial markets already very sensitive to negative
                            sovereign credit news, the potential immediate impact on Treasury yields and other borrowing
                            costs in the U.S. economy could be explosive and recession-causing. All well-informed members
                            of Congress know this too, which is why debt limit crises are really nothing more than exercises
                            in political brinkmanship. But, the longer the delay in raising the ceiling, the more intense the
                            crisis becomes. Once at the limit, the more the Treasury must scramble to find funds to make
                            interest payments.

                                     Fortunately, hitting the debt limit doesn’t automatically trigger default. Once a “debt issuance
                                     suspension period” has been declared (which Mr. Geithner will have done by May 16 if the limit
                                     is not lifted), Treasury can use various manoeuvres to free up a bit of borrowing room to keep
                                     making interest payments and avoid defaulting on the debt (some have congressional approval,
                                                                            others emerge from the power of the office). Fiddling with
                                                                            government employee pension funds (that invest solely in
 CHART 1                                                                    Treasury securities) is a common measure. Treasury can
 LIMIT UP                                                                   stop new investments or re-investments of maturing
 United States (US$ trlns : month-end)                                      securities, and even redeem securities early, in these funds.
 Public Debt                                                                But there are limits to how much can be done, and the
 16                                                                         funds must be made whole, including interest, afterwards.
 14                                                                         In the past, Treasury has also altered the investments of
                                                           Limit            other agencies, to smaller effect.

 10                                                 Outstanding       This raises the issue of whether available manoeuvres,
                                                                      given the growing magnitude of interest payments on the
                                                                      public debt, will be adequate in the future—let alone in
  6                                                                   the current situation. After the last time the debt ceiling
  4                                                                   was raised on February 12, 2010, Secretary Geithner
      97    99      01      03      05      07     09       11
                                                                      decided to ramp up Treasury’s Supplementary Financing

PAGE 6 – FOCUS – JANUARY 21, 2011

                                                                           Account at the Fed (Chart 2). This was originally
 CHART 2                                                                   established during 2008 to help the Fed manage its
 A NEW MANOEUVRE                                                           balance sheet (the Treasury issued securities to help
 United States (US$ blns : month-end)                                      absorb bank reserves, with the proceeds sitting idle in its
 Treasury’s Supplementary Financing Account at the Fed                     account at the Fed). These funds topped more than $555
 600                                                                       billion at the height of the financial crisis, but were
                                                                           eventually drawn down to zero. On February 23, 2010,
                                                                           Treasury announced that the program would be
                                                                           reactivated to $200 billion (no mention about the Fed’s
 300                                                                       balance sheet). Mr. Geithner can draw down on these
 200                                                                       funds to make interest payments. Of course this would
                                                                           mean that the funds would flow into the banking system
                                                                           and boost banks’ reserves. Given that the Fed is
   0                                                                       quantitative easing anyway, this shouldn’t pose a problem
           08                   09                 10             11
                                                                           for monetary policy.

 CHART 3                                                                   Interestingly, the mere existence of congressionally-
 TAKE IT TO THE LIMIT                                                      approved measures to help avoid defaulting probably
 United States (US$ blns : month-end)                                      makes it more likely that the debt ceiling debates will
 Balance of Public Debt Limit                                              drag on, and debt limits will be hit. Arguably, the most
 2000                                                                      famous debt limit/budget crisis was the 1995-1996 clash
                                                                           between the Clinton Administration and the Republican-
 1500                                                                      led Congress, which included two government
                                                                           shutdowns. But smaller crises occurred frequently before
 1000                                                                      (which is why Congress approved Treasury’s ability to
                                                                           fiddle with the pension funds back in the mid-1980s).
  500                                                                      More recently, the public debt was taken to the limit in
                                                                           2002 (twice), 2003, 2004 and early-2006 (Chart 3). During
       0                                                                   the last three episodes, the Bush Administration was
           97    99        01           03    05        07   09   11
                                                                           dealing with a Republican-led Congress, so debt limit
                                                                           crises are not all about partisan politics.

                                     It’s hard to know how prone to political brinkmanship the upcoming debate will be. On the
                                     positive side, the Obama Administration and the previous Congress agreed (including the
                                     Republican leadership) on a fiscal stimulus package last month, suggesting that the debt limit
                                     debate could be less divisive (although some of the new members are taking harder lines). Last
                                     month, the bipartisan National Commission on Fiscal Responsibility and Reform also released their
                                     report, fencing common ground around the inevitable associated debate about future fiscal
                                     policy. However, a January 12 Ipsos/Reuters poll revealed that 71% of Americans oppose raising
                                     the debt ceiling. Apart from showing that 71% of Americans don’t adequately understand the
                                     issue they are being polled on, the populists and Tea Party types could seize on such misguided
                                     sentiment to pressure increased congressional intransigence.

PAGE 7 – FOCUS – JANUARY 21, 2011

                                                                                                 Bottom line: The current debt ceiling debate will likely go
 TABLE 1                                                                                         down to the wire, similar to many of its predecessors, and
 $14 TRILLION... AND COUNTING                                                                    perhaps elicit limit-skirting measures to make sure interest
 United States (US$ blns : as of December 31, 2010)                                              payments are made. In the end, the debt limit will be lifted
 Public Debt                                                                                     before the government is ultimately forced to default.
                                                Held by Intragovernmental
                                              the Public          Holdings           Total *     Appendix: Detailing the Debt
 Marketable Securities                            8,841                 22          8,863
                                                                                                 The U.S. public debt stood at $14,025 billion at the end of
 Non-Marketable Securities                          549              4,613          5,162
 Total *                                          9,390             4,635          14,025        2010 (Table 1) and, despite its name, it’s not all held by the
                                                                                                 “public” in the form of marketable Treasury securities (bills,
 Not Subject to the Debt Limit                       21                  31            53
 Subject to the Limit                             9,369               4,603        13,972
                                                                                                 notes, bonds and TIPs). About 33% of the public debt is
 Statutory Debt Limit                                                              14,294        intragovernmental holdings, mostly made up of
 Balance of Statutory Debt Limit                                                      321        nonmarketable Treasury securities that are mostly held by
 * totals may not add up due to rounding
                                                                                                 government trust funds as investments. For example, of
                                                                                                 the $4,634 billion in intragovernmental holdings, more
                                                                                                 than 56% is the two Social Security trust funds and almost
                                                                                                 17% is the Civil Service Retirement and Disability Fund.
 United States (US$ blns)                                                                        Nearly all public debt (99.6%) is subject to debt limit.
   400                                                                                  14,000
                                                                                                 Changes in the public debt do not match total budget
      0                                                                                 12,000   balances because these balances incorporate such things
                                  Total                                                 10,000   as the excess of social security contributions over benefit
  -400                           Budget                                                          payments (the latter are referred to as “off budget” items).
                                 Balance                                                8,000
                                     (lhs)                                                       Although this reduces the reported total budget deficit or
                                                                                        6,000    raises the surplus, the Social Security trust funds are still
 -1,200                                       Public                                             credited with the premiums in the form of nonmarketable
                                               Debt                                     4,000
                                               (rhs)                                             securities, and the public debt continues to rise. The year
 -1,600                                                                                 2,000
          90     92     94      96       98     00     02   04   06   08      10                 2000 was the only time that the public debt actually
 Total Budget Balance = (12-mnth m.s.) Public Debt = (12-mnth m.a.)                              stabilized, as the surplus in “on-budget” items matched
                                                                                                 the surplus in “off budget” items (Chart 4).

PAGE 8 – FOCUS – JANUARY 21, 2011
                                                                                                              Economic Forecast

                                                                        2010                                 2011                         ANNUAL
  CANADA                                                 I         II          III     IV        I      II          III     IV    2010     2011 2012
  Real GDP (q/q % chng : a.r.)                         5.6        2.3       1.0        2.0     3.4     3.1          3.0     2.9     2.9      2.7     2.6
  Consumer Price Index (y/y % chng)                    1.6        1.4       1.8        2.1     2.1     2.6          2.4     1.5     1.7      2.1     1.9
  Unemployment Rate (%)                                8.2       8.0       8.0         7.7    7.6     7.6        7.5        7.4    8.0      7.5      7.2
  Housing Starts (000s : a.r.)                        198        199       192        182     170     179       182        185     193      179     182
  Current Account Balance ($blns : a.r.)             -36.7      -51.9     -70.1      -53.3   -55.5   -55.7     -54.3      -54.5   -53.0    -55.0   -57.0
  Interest Rates
  (average for the quarter : %)
  Overnight Rate                                      0.25       0.33      0.83       1.00   1.00     1.17      1.50       1.83    0.60     1.38    3.06
  3-month Treasury Bill                               0.19       0.41      0.70       0.94   0.98     1.16      1.50       1.83    0.56     1.37    3.06
  10-year Bond                                        3.47       3.47      3.01       3.00   3.24     3.26      3.45       3.64    3.24     3.40    4.04
  Canada/U.S. Interest Rate Spreads
  (average for the quarter : bps)
  90-day                                                8         26           54      80      84     102       136        169      42      123     178
  10-year                                             -25         -2           22      13     -15      -3       -13        -22       2      -13     -40
  Real GDP (q/q % chng : a.r.)                         3.7        1.7       2.6        3.2     3.5     3.4          3.3     3.5     2.9      3.2     3.0
  Consumer Price Index (y/y % chng)                    2.4        1.8       1.2        1.2     1.3     1.8          1.9     1.5     1.6      1.6     1.5
  Unemployment Rate (%)                                9.7        9.6       9.6        9.6    9.4      9.2       8.9        8.7     9.6      9.1     8.3
  Housing Starts (mlns : a.r.)                        0.62       0.60      0.59       0.54   0.58     0.61      0.64       0.70    0.59     0.63    0.85
  Current Account Balance ($blns : a.r.)             -437       -493      -509       -482    -494    -501       -509      -516    -480      -505   -510
  Interest Rates
  (average for the quarter : %)
  Fed Funds Target Rate                               0.13       0.13      0.13       0.13   0.13     0.13      0.13       0.13    0.13     0.13    1.29
  3-month Treasury Bill                               0.11       0.15      0.15       0.14   0.14     0.14      0.14       0.14    0.14     0.14    1.29
  10-year Note                                        3.72       3.49      2.79       2.86   3.39     3.29      3.58       3.86    3.21     3.53    4.44
  (average for the quarter)
  US¢/C$                                             96.0        97.3      96.3       98.7    99.7   100.0     100.9      102.1    97.1    100.7   101.2
  C$/US$                                            1.041       1.028     1.039      1.013   1.003   1.000     0.991      0.979   1.030    0.993   0.989
  ¥/US$                                                91          92        86         83      84      84        84         85      88       84      90
  US$/Euro                                            1.38       1.27      1.29       1.36   1.31     1.27      1.28       1.33    1.33     1.30    1.30
  US$/£                                               1.56       1.49      1.55       1.58   1.54     1.51      1.53       1.58    1.55     1.54    1.57
  Note: Blocked areas represent BMO Capital Markets forecasts
  Up and down arrows indicate changes to the forecast

PAGE 9 – FOCUS – JANUARY 21, 2011
                                                                                  Key for Next Week

                                    CANADA                                  Douglas Porter, CFA, Deputy Chief Economist
Consumer Price Index                Canadian consumer prices have dropped in each of the past two Decembers on
Tuesday, 7:00 am                    heavy-duty discounting and lower energy prices. We suspect 2010 will show a
           m/m (nsa)        y/y     different result, as gasoline prices powered up more than 3% in the month, and at
Dec. (e)   +0.1%            +2.4%
           (+0.4% sa)               least some of the typical seasonal discounting may have been brought forward into
 Consensus +0.2%            +2.5%   November (as some Canadian stores mimicked the U.S. Black Friday). Accordingly, we
Nov.       +0.1%            +2.0%
                                    are looking for a 0.1% m/m rise in overall prices (or roughly 0.4% in seasonally
           Core CPI
Dec. (e)   +1.7% y/y                adjusted terms, nearly matching the 0.5% rise seen in the U.S. CPI last month). Even
 Consensus +1.6% y/y                this modest rise would be enough to bump up the inflation rate to 2.4% y/y, and could
Nov.       +1.4% y/y
                                    push up the average inflation rate for all of 2010 to 1.8% (from a microscopic 0.3% in
                                    2009). Recall that the HST added 0.7 percentage points to the inflation rate, and
                                    without that special factor, underlying inflation would still be comfortably below 2%.

                                    The Bank of Canada’s measure of core CPI is expected to dip 0.1% in December, but,
                                    due to much heavier discounts a year ago, that would still lift the annual trend to 1.7%
                                    (from a low 1.4% in November). The Bank looks for core CPI to dip to a 1.4% y/y
                                    average in Q1, and then begin grinding higher through 2011 and 2012, finishing next
                                    year at 2%. Core inflation will take a big temporary spill in two months, when a
                                    temporary Olympics-related jump falls out of the index.

                                    UNITED STATES                                           Sal Guatieri, Senior Economist
Conference Board Consumer           Rising equities and falling Social Security contributions likely lifted consumer spirits
Confidence Index                    modestly in the New Year, despite the hangover from higher gasoline prices. Barring a
Tuesday, 10:00 am                   sharper increase, however, confidence will have made little headway in the past year.
Jan. (e)    53.0
  Consensus 54.2
                                    While much improved from the Great Recession lows, consumer sentiment appears
Dec.        52.5                    stuck at typical recession levels until job growth strengthens.

New Home Sales                      New home sales likely rose for the second straight month in December, albeit from
Wednesday, 10:00 am                 rock-bottom levels. Even an expected 5% increase to 305,000 units (annualized) would
Dec. (e)   305,000 a.r. (+5.0%)     leave sales at less than half their normal rate and not far from last summer’s all-time
 Consensus 300,000 a.r. (+3.4%)
Nov.       290,000 a.r. (+5.5%)     low (274,000). A flood of cheap distressed properties continues to siphon demand
                                    from the new home market. Despite lean supply on builder lots, prices have slipped in
                                    the past year owing to even leaner demand. Still, a portion of the recent pickup in
                                    resale demand should start to rub off on the new home market.

Fed Policy Meeting                  A lineup change should result in the first FOMC meeting since December 2009
Announcement on                     without a dissenting vote. Although two hawkish regional presidents (Plosser and
Wednesday, 2:15 pm                  Fisher) will replace one (Hoenig), neither are expected to vote against ending the
                                    current Treasury purchase program (which is slated to run through June), though they
                                    won’t actually give it a ringing endorsement either. Look for the press statement to
                                    assert that, while the recovery has become more self sustaining, further progress is
                                    needed to meaningfully reduce unemployment and deflation risks. Also look for the
                                    statement to retain the “extended period” language on maintaining low rates.

PAGE 10 – FOCUS – JANUARY 21, 2011
                                                                                                  Key for Next Week

Durable Goods Orders                   After dipping in November, durable goods orders likely rebounded 1.5% in December
Thursday, 8:30 am                      on the back of higher aircraft and machinery sales. Capital goods orders (excluding
Dec. (e)   +1.5%        +0.8%          aircraft and defense) likely rose for the second straight month, indicating that business
 Consensus +1.5%        +1.0%
Nov.       -0.3%        +3.6%          capital spending continues to grow strongly, likely by 8% annualized in Q4 following
                                       the fastest pace in a quarter century in the previous year (19%).

Real GDP                               The U.S. economy likely ended 2010 on an upswing, growing an estimated 3.2%
Friday, 8:30 am                        annualized compared with 2.6% in Q3. Business capital spending and exports
                        GDP Deflator   probably remained solid, while consumers look to have put in their best showing (4%)
Q4 A (e)   +3.2% a.r.   +1.4% a.r.
 Consensus +3.5% a.r.   +1.7 % a.r.    in four years. But not every cylinder in the economy is pumping. Soft spots likely
Q3         +2.6% a.r.   +2.1 % a.r.    include a further slide in residential and commercial construction, less inventory
                                       rebuilding (after a record boost in Q3), and ongoing belt-tightening at the municipal
                                       level. Despite these speed-bumps, however, the recovery train keeps chugging along
                                       now that the consumer has hopped on board. Final sales (GDP less inventories)
                                       probably grew 5%, the fastest clip in 4½ years.

PAGE 11 – FOCUS – JANUARY 21, 2011
                                                            Financial Markets Update
                                                                     CHANGE FROM: (BASIS POINTS)
                                         JAN 21 *   JAN 14      WEEK AGO   4 WEEKS AGO      DEC. 31/10
   Canadian Money Market
      Call Money                           1.00      1.00           0             0              0
      Prime Rate                           3.00      3.00           0             0              0
   U.S. Money Market
      Fed Funds (effective)                0.25      0.25           0             0              0
      Prime Rate                           3.25      3.25           0             0              0
   3-Month Rates
      Canada                               0.97      0.96           1             -1             0
      United States                        0.15      0.15           1             2              3
      Japan                                0.20      0.11           9             7              8
      Eurozone                             1.03      1.01           2             1              2
      United Kingdom                       0.78      0.77           1             2              2
      Australia                            4.91      4.91           0             1              1
   Bond Markets
   2-year Bond
      Canada                               1.74      1.78           -5            3              6
      United States                        0.62      0.57           5             -3             2
   10-year Bond
      Canada                               3.34      3.27            8            18            22
      United States                        3.45      3.33           12             5            15
      Japan                                1.21      1.21            0             5             8
      Germany                              3.18      3.03           15            20            22
      United Kingdom                       3.70      3.61            9            19            31
      Australia                            5.65      5.55           11            -2            11
   Risk Indicators
      VIX                                  17.0      15.5         1.5 pts       0.5 pts       -0.8 pts
      TED Spread                            15        16            -1             -2            -3
      Inv. Grade CDS Spread **              85        83             1             -1             0
      High Yield CDS Spread **             416       411             5            -21           -14
   Currencies                                                                (% CHANGE)
      US¢/C$                              100.73    100.92         -0.2           1.6          0.5
      C$/US$                              0.993     0.991          —             —             —
      ¥/US$                               82.74     82.87          -0.2          -0.2          2.0
      US$/Euro                            1.3556    1.3388          1.3           3.3          1.3
      US$/£                               1.597     1.587           0.6           3.4          2.3
      US¢/A$                              98.94     98.88           0.1          -1.5          -3.3
      CRB Futures Index                    333.40    333.06         0.1           1.2          0.2
      Oil (generic contract)               89.25     92.57         -3.6          -2.5          -2.3
      Natural Gas (generic contract)        4.72      4.48         5.3           15.5          7.1
      Gold (spot price)                   1342.58   1361.72        -1.4          -2.8          -5.5
      S&P/TSX Composite                   13372     13464          -0.7          -0.1          -0.5
      S&P 500                             1286      1293           -0.5           2.4          2.3
      Nasdaq                              2712      2755           -1.6           1.7          2.2
      Dow Jones Industrial                11875     11787           0.7           2.6           2.6
      Nikkei                              10275     10499          -2.1           0.0          0.4
      Frankfurt DAX                       7090      7076            0.2           0.5          2.5
      London FT100                        5924      6002           -1.3          -1.4          0.4
      France CAC40                        4036      3983            1.3           3.5          6.1
      S&P ASX 200                         4756      4802           -1.0          -0.5          0.2
   * as of 10:30 am   ** One day delay

PAGE 12 – FOCUS – JANUARY 21, 2011
                                                  JANUARY 24 – JANUARY 28                                                                                      Global Calendar
                  MONDAY JANUARY 24                       TUESDAY JANUARY 25                    WEDNESDAY JANUARY 26                THURSDAY JANUARY 27                    FRIDAY JANUARY 28

                                                                                                                               Merchandise Trade Surplus                        CPI         Core CPI
                                                                                                                               Dec. ’10 (e) ¥465 bln               Dec. (e)     -0.1% y/y   -0.5% y/y
                                                                                                                               Dec. ’09 (e) ¥543 bln               Nov.         +0.1% y/y   -0.5% y/y
                                                                                                                                                                   Jobless Rate
                                                                                                                                                                   Dec. (e)     5.1%
                                                                                                                                                                   Nov.         5.1%
                                                                                                                                                                   Retail Sales
                       Bank of Japan Monetary Policy Meeting (January 24-25)                        BoJ Monthly Report
                                                                                                                                                                   Dec. (e)     -1.4%       +0.6% y/y
                                                                                                                                                                   Nov.         +2.1%       +1.5% y/y
                                                                                                                                                                   Household Spending
                                                                                                                                                                   Dec. (e)     -0.6% y/y
                                                                                                                                                                   Nov.         -0.4% y/y

                    EUROZONE                                 GERMANY                                    ITALY                           EUROZONE                             EUROZONE
           Manufacturing PMI                       GfK Consumer Confidence                 Retail Sales                        Economic Confidence                 M3 Money Supply (smoothed)
           Jan. A (e) 57.0                         Feb. (e) 5.4                            Nov. (e) unch           -0.8% y/y   Jan. (e)   106.7                    Dec. (e)  +1.6% y/y
           Dec.        57.1                        Jan.      5.4                           Oct.         +0.3%      -0.6% y/y   Dec.       106.2                    Nov.      +1.3% y/y
           Services PMI                                        FRANCE                                                                    GERMANY
           Jan. A (e) 54.3                         Consumer Spending                                                           Consumer Price Index
           Dec.        54.2                        Dec. (e)  +0.3%             +0.5% y/y                                       Jan. P (e) -0.4%        +2.2% y/y
           Industrial New Orders                   Nov.      +2.8%             +1.5% y/y                                       Dec.       +1.2%        +1.9% y/y
           Nov. (e) +2.0%          +17.1% y/y
           Oct.        +1.4%       +14.8% y/y

                                                   Real GDP
                                                   Q4 A (e) +0.5%              +2.6% y/y
                                                   Q3       +0.7%              +2.7% y/y      Minutes from the January 12-13
                                                                                               BoE Monetary Policy Meeting

                    AUSTRALIA                               AUSTRALIA
           Producer Price Index                    Consumer Price Index
           Q4 (e)     +0.5%        +3.2% y/y       Q4 (e)    +0.8%             +3.0% y/y
           Q3         +1.3%        +2.2% y/y       Q3        +0.7%             +2.8% y/y

                                                          Reserve Bank of India
                                                         Monetary Policy Meeting
                                                      JANUARY 24 – JANUARY 28                                                                   North American Calendar
                      MONDAY JANUARY 24                      TUESDAY JANUARY 25                   WEDNESDAY JANUARY 26                     THURSDAY JANUARY 27                           FRIDAY JANUARY 28

                Ottawa’s Budget Balance **            7:00 am     Consumer Price Index                                                                                        8:30 am      Payroll Employment
                Nov. ’10                                          m/m (nsa) y/y                                                                                               Nov. (e)     +14,000
                Nov. ’09   -$4.4 bln                  Dec. (e)    +0.1%        +2.4%                                                                                          Oct.         -10,447
                                                                  (+0.4% sa)
                                                        Consensus +0.2%        +2.5%
                                                      Nov.        +0.1%        +2.0%
                                                      7:00 am Core CPI
                                                      Dec. (e)    +1.7% y/y
                                                        Consensus +1.6% y/y                  12:05 pm 2-year bond auction
                                                      Nov.        +1.4% y/y                           $3.0 bln
                                                                                                      (New cash $3.0 bln)            10-year bond auction announcement

                                                      8:55 am Redbook Same-Store Sales       7:00 am       MBA Mortgage Apps         8:30 am    Initial Claims                8:30 am     Real        GDP
                                                      Jan. 22                                Jan. 21                                 Jan. 22 (e)409k (+5k) *                              GDP         Deflator
                                                      Jan. 15 (mtd) -0.6% m/m +2.7% y/y      Jan. 14       +5.0%                     Jan. 15    404k (-37k)                   Q4 A (e) +3.2% a.r. +1.4% a.r.
                                                      9:00 am S&P Case-Shiller Home          10:00 am      New Home Sales            8:30 am    Continuing Claims               Consensus +3.5% a.r. +1.7 % a.r.
                                                                    Price Index              Dec. (e)      305,000 a.r. (+5.0%)      Jan. 15 (e)3,880k (+19k) *               Q3          +2.6% a.r. +2.1 % a.r.
                                                      Nov. (e) -1.4% y/y                       Consensus   300,000 a.r. (+3.4%)      Jan. 8     3,861k (-26k)                 8:30 am Employment Cost Index
                                                      Oct.          -0.8% y/y                Nov.          290,000 a.r. (+5.5%)      8:30 am    Durable                       Q4 (e)      +0.5%       +2.0% y/y
                                                      10:00 am FHFA House Price Index                                                           Goods          Ex.              Consensus +0.5%       +2.0% y/y
                                                      Nov. (e) -3.6% y/y                                                                        Orders         Transport      Q3          +0.4%       +1.9% y/y
                                                      Oct.          -3.4% y/y                                                        Dec. (e)   +1.5%          +0.8%          9:55 am Univ. of Michigan
                                                      10:00 am Conference Board                                                       Consensus +1.5%          +1.0%                      Consumer Sentiment
                                                                    Consumer Confidence                                              Nov.       -0.3%          +3.6%          Jan. F (e) 73.0
                                                                    Index                                                            10:00 am Pending Home Sales                Consensus 73.0
                                                      Jan. (e)      53.0                                                             Dec. (e)   -1.0%                         Jan. P      72.7
                                                        Consensus 54.2                                                                Consensus +1.0%                         Dec.        74.5
                                                      Dec.          52.5                                                             Nov.       +3.5%
                                                      5:00 pm ABC News Consumer
                                                                    Comfort Index
                                                      Jan. 23
                                                      Jan. 16       -43
                                                       9:00 pm President Obama’s
                                                               State of the Union Address

                                                                  FOMC Meeting (Announcement on Wednesday, 2:15 pm)
                                                                                                                                     11:00 am    13- & 26-week bill auction
                11:30 am 13- & 26-week bill auction   1:00 pm     2-year note auction                                                1:00 pm 7-year note auction
                            $57.0 bln                             $35.0 bln                                                                      $29.0 bln
                Fed to purchase $7-9 bln of notes     Fed to purchase $8-9 bln of notes      1:00 pm       5-year note auction       Fed to purchase $4-6 bln of bonds        Fed to purchase $7-9 bln of notes
                (July 2016-Dec. 2017)                 (Jan. 2015-June 2016)                                $35.0 bln                 (July 2012-July 2013)                    (Feb. 2018-Nov. 2020)

* consensus ** date approximate                                    Upcoming Policy Meetings Bank of Canada: Mar. 1, Apr. 12, May 31 FOMC: Mar. 15, Apr. 26-27, June 21-22
                                 The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice.
                                 Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Bank of Montreal
                                 (“BMO”) and its affiliates make every effort to ensure that the contents thereof have been compiled or derived from sources believed to be reliable and to contain
                                 information and opinions which are accurate and complete. However, neither BMO nor its affiliates have independently verified or make any representation or
                                 warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which may be contained herein or accept any liability
                                 whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied
                                 upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to BMO
                                 and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an
                                 offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other
                                 financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation
                                 to enter into any transaction. Additional information is available by contacting BMO or its relevant affiliate directly. BMO and/or its affiliates may make a market or
                                 deal as principal in the products (including, without limitation, any commodities, securities or other financial instruments) referenced herein. BMO, its affiliates,
                                 and/or their respective shareholders, directors, officers and/or employees may from time to time have long or short positions in any such products (including,
                                 without limitation, commodities, securities or other financial instruments). BMO Nesbitt Burns Inc. and/or BMO Capital Markets Corp., subsidiaries of BMO, may act
                                 as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. “BMO Capital Markets” is a trade
                                 name used by the Bank of Montreal Investment Banking Group, which includes the wholesale/institutional arms of Bank of Montreal, BMO Nesbitt Burns Inc., BMO
                                 Nesbitt Burns Ltée/Ltd., BMO Capital Markets Corp. and Harris N.A., and BMO Capital Markets Limited.

                                 TO U.S. RESIDENTS: BMO Capital Markets Corp. and/or BMO Nesbitt Burns Securities Ltd., affiliates of BMO NB, furnish this report to U.S. residents and accept
                                 responsibility for the contents herein, except to the extent that it refers to securities of Bank of Montreal. Any U.S. person wishing to effect transactions in any
                                 security discussed herein should do so through BMO Capital Markets Corp. and/or BMO Nesbitt Burns Securities Ltd.

                                 TO U.K. RESIDENTS: The contents hereof are not directed at investors located in the U.K., other than persons described in Part VI of the Financial Services and
                                 Markets Act 2000 (Financial Promotion) Order 2001.

                                 ™ - “BMO (M-bar roundel symbol) Capital Markets” is a trade-mark of Bank of Montreal, used under licence. © Copyright Bank of Montreal.

PAGE 15 – FOCUS – JANUARY 21, 2011

Shared By: